At 645 Ventures, we believe that new technology waves catalyze the creation of new industries and the formation of category-defining startups. In fintech, over the past decade we’ve witnessed the creation of entirely new categories of massive startups due to the growth of online financial marketplaces, the growth of big data that enables personalized financial products, and the proliferation of mobile financial apps. These areas include online lending (Affirm, Lending Club), personal finance (Credit Karma), payments (Square and Stripe), and retail investing (Robinhood), just to name a few.
Over the past few years, there has been a focus on the plumbing and infrastructure software that enables consumer fintech applications to exist and scale. There is no better example than Plaid, whose success has had an incredibly outsized impact on the proliferation of fintech infrastructure startups. Additional growing infrastructure companies include Finix and Infinicept, in addition to the aforementioned Stripe and Square that also play a major role in this market.
However, “fintech” is no longer restricted to companies that are reimagining traditional financial services. Rather, it also describes companies in a number of different categories, including e-commerce, vertical SaaS, and marketplaces, that are bundling financial products with their core offerings. As an example, Shopify now generates ~69% of its revenue, or $2.0 billion from “Merchant Solutions”, which comprises payment processing, recurring billing, mobile payments, and fraud management, among other services. Uber sends more than 70% of its driver payouts through Instant Pay, which is its embedded banking service. (1)
At 645, we believe that we are only in the early stages of the embedded finance revolution, and that integrating financial services will increasingly become the norm for software companies as they scale their consumer and enterprise offerings. For example, according to Lightyear Capital, embedded finance will grow from a $22.5 billion market in 2020 to nearly $230 billion by 2025, representing a CAGR of nearly 60% (2). We are witnessing the rise of standalone companies that simplify and reduce the cost of providing these financial products and services. And while much has been written about defining embedded finance and the types of companies that are evolving, there has been a lack of information for founders on how they should approach the decision to offer financial products alongside their core offerings.
In order to shed light on this topic, we created a guide for founders by interviewing several entrepreneurs and key executives who have successfully integrated financial products and services into their offerings. We also interviewed successful investors in embedded finance companies, as well as technology providers that enable embedded finance products and services. Here is what we learned:
Consider both the Roadblock and the Opportunity: With the recent focus on embedding financial products, it’s easy for companies to get swayed by the allure of a new, buzzy feature. However, the best approach is to think carefully about the needs of your end customers, how best to serve them, and whether a new product can generate meaningful value for them. When asked about how they evaluated new financial products, Matthew Garippa, the Chief Business Officer at 645 portfolio company Negotiatus, simply stated that their “first foray into payments was to remove a blocker” for their customers. In Negotiatus’ case, clients were having a difficult time paying manually, and enabling a new payments option dramatically improved the user experience, making it both easier and faster for both parties.
According to Ted VanDeburg at Infiniciept, which helps companies become PayFacs, owning the customer journey is another reason software companies should seek to embed payments. In this case, the roadblock might be that referring clients to an outside 3rd party for payments significantly impacts customer satisfaction, while owning payments removes this burden. Your company might also be able to provide payments with lower fees, due to the removal of fees that would typically be paid to processors and / or other third parties. In other instances, clients might benefit from better working capital solutions, in which case it might be more useful to consider facilitating loans that enable long-term expansion. For example, Level helps independent contractors access innovative working capital products for items such as tools, equipment, vehicles, and more. Companies that partner with Level not only provide new financial products to their customers, but also potentially increase revenue per client as their business grows. In summary, a clear focus on the end customer will help guide you on whether or not it makes sense to integrate financial services, and if so, which product.
Think beyond Payments: While payment processing is often the first product companies consider integrating, due to the size of the potential revenue opportunity, there are additional, lucrative products and services. Therefore, it’s helpful to think beyond payments and focus on the needs of the specific vertical. Embedded fintech also provides expansion opportunities into areas such as lending, insurance, cards, invoice factoring, and even tangential products such as payroll & benefits. While the software infrastructure to support these additional products is nascent, we’re starting to see more startups focused on providing the same type of seamless integration that we have historically seen only for payments. If implemented correctly, these new products will not only create new revenue streams, but also meaningfully improve the user experience.
For example, Hostos Monegro, Director of Product Management at LeafLink, considered invoice factoring as their first financial product given the unique needs of their customers. In this case, the company purchases invoices from Cannabis brands at a discount and then provides adjusted terms to dispensaries, speeding up time to payment for suppliers while enabling dispensaries to better manage working capital needs.
Driven by its data-driven insights, Toast launched Toast Capital in 2019, allowing its restaurant customers to secure loans that fit their unique needs. Steve Fredette, Co-Founder of Toast, noted that Toast is able to provide its customers with quick and simple access to loans, because the platform has already completed KYC & compliance requirements on its customers, and can also offer better pricing due to the unique data and deep understanding of its customers.
As we look beyond payments, the market opportunity for such lending & insurance products could be equivalent if not greater than payments. According to Simon Torrence, the three products together comprise an addressable market of ~$7.2 trillion (3), with $3 trillion for insurance alone (4).
Use ROI to Guide Launch Timing: One of the key questions as it relates to the right time to consider a new financial product is whether the ROI meets your target hurdle rate. For example, the Infinicept team requires at least $50m of gross processing volume per year in order to justify the investment in people & tools. You may seek a higher level of minimum gross processing volume in order to meet your company’s target return on capital. Outside of cost, the timing of a new product introduction also requires critical thinking around the needs of the customer as a company’s platform matures, as well as the available resources that can be dedicated to servicing this product.
Lastly, we also believe timing has a lot to do with the available infrastructure as it relates to financial technologies. For example, before the arrival of PayFac companies, bringing payments in-house was price-prohibitive for most software companies, but this is not the case anymore. Charles Birnbaum, Partner at Bessemer, described a shifting of gears in fintech right now as it's becoming easier to launch niche financial products. Companies such as Stripe, Finix, Plaid, Alloy, and Lithic have made it vastly easier to build, deploy, and embed payments & other financial applications.
We believe the same pattern will hold for a much broader array of financial services. As we look forward to innovations in areas such as crypto, blockchain technology, NFTs, and DeFi, we believe a new generation of infrastructure companies will enable the same type of proliferation of financial innovation. For example, new startups are making it much easier to launch blockchain applications, accept cryptocurrencies as payment, or convert a product into a one-of-a-kind digital good. Solidus Labs, a 645 portfolio company, is one such example of a company that provides much-needed crypto infrastructure, by creating the first automated market surveillance and risk monitoring hub tailored for digital assets.
Balance Buy vs. Build: Once the determination to embed a financial product has been made, the next question that typically comes up is whether to build functionality internally, partner with an external provider, or adopt a hybrid approach. We found that the most thoughtful teams carefully consider how to leverage proprietary data while partnering with a best-in-class partner for non-core functionality. For example, Hostos from LeafLink, noted that their “model is proprietary” to LeafLink, but they partner with external platforms to assist with the credit implications. One of the advantages of this model is that LeafLink can draw upon the set of data that is uniquely available to them, creating a competitive moat and tailoring products for their clients.
Similarly, 645 portfolio company Squire, has arguably the most unique data available on barbershops, which provides the opportunity to offer a broad range of financial services. Their current financial products include One Touch Payout, Smart Rent Collection, and Gift Cards. Regardless of the approach that is chosen, embedding financial products usually requires adding a new set of capabilities to the team. According to Infinicept, it’s important to invest in “tools, people, and process” in order to effectively manage risk as well as compliance.
Underwriting Matters: Building upon the last point, it’s also important to consider the types of data you can gather from a new type of financial offering. This can help inform how to improve your underwriting model, evaluate new products, and better tailor terms to a specific customer. When launching their payments offering, Matt from Negotiatus mentioned they were specifically “looking for a partner that would expose more data to them,” as opposed to a 3rd party platform that blocks access to data collection & analysis. This type of partnership is crucial to ensure that regardless of the offering, the platform is always iterating and improving upon the user experience.
Rebecca Liu-Doyle from Insight Partners noted that there is an important distinction between startups that are just a marketplace providing access to different providers, and those that truly assist with underwriting services. Looking deeply at the partnership from a technology perspective is very important before choosing the right partner, which includes looking at how well documented the API is (if available) as well as evaluating the team and how knowledgeable they are about the needs of the market.
Measure the ROI of a Partnership: From a cost perspective, we recommend breaking down the cost of a potential partner into different components. If a provider is owning all of the credit and execution risk, the fees will potentially be higher, vs. a pure marketplace where the fee will look more like a broker fee. This reduces your margin, but the trade-off may be worth it if you are seeking to de-risk and reduce up-front costs. Regardless of structure, measuring the ROI will help ensure the right financial product was chosen, and how to expand upon this in the future.
As such, we recommend thinking through these considerations at the beginning of the process, and re-evaluating post product launch in order to benchmark the success against initial expectations. For example, Paul Sirisuphang, COO & Co-founder of 645 portfolio company RentSpree, noted that “when they began to consider offering rent payment & renter’s insurance, they thought about the entire rental journey” and they associated business value to each feature. This enabled them to hone in which features would be most important to their customers, and use that as a guiding framework for new product introductions. Similarly, Steve Fredette, Co-Founder of Toast, mentioned their team thinks about ROI for every decision they make, and strives to make as many data-driven decisions as possible.
Looking forward, we expect to see a continuing convergence between fintech services and vertical software, and we hope these innovations will ultimately provide end customers with more personalized and better priced financial products and services. From our conversations, we’ve learned that the most important first steps are to find the right market and focus on growing a proprietary customer base.
Over time, introducing new financial products can become the future of the platform and initiate a new type of customer experience for the original clients. While this motion is still in its early days, especially for products outside of traditional payments, we are excited to work with founders who are customer obsessed and living in the future. Please reach out to us at firstname.lastname@example.org and email@example.com if you’re building in, investing in, or thinking about these categories.
^1: “Boom of Embedded Finance in 2021: An Expert Overview,” Relevant, at https://relevant.software/blog/embedded-finance-expert-overview/.
^2: “Uber’s Departure From Financial Services: A Speed Bump On The Path To Embedded Finance” at https://www.forbes.com/sites/ronshevlin/2020/08/03/ubers-departure-from-financial-services-a-speed-bump-on-the-path-to-embedded-finance